The Unintended Consequences Of Central Bank Policies

Central bank efforts to save the world economy after the 2007-2009 financial crisis were much lauded by pundits these past few years. But now researchers are digging up evidence that some of their actions resulted in significant unintended consequences. Sometimes the results were the opposite of those desired by the policymakers.

A case in point is the European Central Bank (ECB), which fills a similar role to the U.S.-based Federal Reserve in managing a stable price level and helping maintain full employment. Its actions in the bond market effectively funneled more than $1 billion of risk-free profits into the pockets of private financiers, according to new research. The money came in addition to the taxpayer-financed bailouts which saved multiple financial institutions across the world.

This article is part one of a two-part series. It deals with distortions in Europe's government bond market. For part two, which deals with negative interest rates, click here.

The headquarters of the European Central Bank. (Photo by DANIEL ROLAND/AFP/Getty Images) Photo credit: AFP/Getty Images

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Just like the Federal Reserve did before it, the ECB engaged in a multi-trillion euro bond-buying program designed to lower the absolute level of interest rates in the countries of the eurozone, Europe's single currency area.

Unfortunately, that program had the unintended consequence of messing up Europe's bond market so allowing private financiers to profit via riskless trades to the tune of hundreds of millions of euros, new research shows.

It happened over the period 2015 to 2017 and the problem was revealed through a recent working paper titled "Central Bank-Driven Mispricing" by researchers at Research Center SAFE - Goethe University Frankfurt and Ca’ Foscari University of Venice, Stern School of Business at New York University, Darden School of Business at University of Virginia, and Waseda University.

The report clearly states that the ECB disrupted the financial markets for key government securities in Europe:

We show that bond purchases undertaken in the context of quantitative easing efforts by the European Central Bank created a large mispricing between the market for German and Italian government bonds and their respective futures contracts.

In other words, the interest rates indicated in the bond market didn't match those in the futures market. When the two are working correctly and efficiently, then they should both show the same result.

This distortion allowed traders to easily make money by profiting from the different prices in the two markets. For instance, a trader might sell a futures contract and buy the corresponding government bond, so cashing in on the difference in rates in each market.

For these so-called arbitrageurs, there was no risk involved. Every time they made such a trade they were basically guaranteed a profit.

"The ECB’s intervention’s effect [...] is tantamount to a direct transfer from taxpayers to arbitrageurs," the report states.

At the height of the bond-buying program, there were approximately 10 trillion euros ($11.4 trillion) of the bonds in question in the market, the report states.

And that meant that even small distortions between the bond market and the futures market could yield enormous profits to traders.

The report's authors estimate that the total "transfer" from taxpayers to traders could have been as high as 1.46 billion euros ($1.66 billion).

The lack of agreement between the interest rates indicated by the bond market and the futures market could send conflicting signals. And that, in turn, messes up the monetary policy that the central bank was trying to execute.

The market for interest rates should be informative for monetary policy to be effective, and it is in the policy makers’ interests that market participants agree on what the “correct” interest rate is.

In other words, the market signals about the ECB's policy were ambiguous, and that presents a problem for the central bank when it tries to implement its policies.

The whole matter including allowing traders to profit from the market distortions, "needs to be examined more closely," the report says.